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04/26/2009

Is the Federal Reserve Losing Its Independence? Posner

Even in a democracy, it is believed that certain government functions should be placed beyond the control of democratic politics. The usual example is the judiciary (though most state judges in the United States are elected, this is a considerable anomaly). But another example is the central bank, which in the case of the United States is the Federal Reserve. A central bank has considerable, often decisive, influence over short-term interest rates, and, through them, over long-run interest rates as well. Typically (and to oversimplify), a central bank reduces short-term interest rates by buying short-term government securities, which pumps cash into the economy when the cash is deposited in bank accounts and then withdrawn and spent. Interest is the price that people or firms demand to part with cash--the more cash there is in the economy, the lower that price will be. In addition, by increasing the demand for these securities, the purchase increases their price, which in turn reduces their yield--the interest that they command. The central bank increases short-term interest rates by the reverse operation--selling short-term government securities, which sucks cash out of the economy, since the central bank can retire the cash rather than having to spend it.
Long-term rates tend to follow the path of short, both because of substitutability and because the more cash the banks have to lend, and so the less they have to pay for the capital that they lend, the lower the interest rates at which they will lend, including lending long term, because competition will tend to keep the spread between the banks' borrowing and lending costs from increasing just because their borrowing costs are falling.
The reason for making the central bank politically independent is that the bank's power over interest rates could be abused for political ends. Suppose the economy, though not in recession, is somewhat sluggish, and the government, perhaps because an election is looming, wants to juice it up. So it orders the central bank to reduce interest rates by buying government securities, thus pumping money into the economy. Reduced interest rates will stimulate lending, borrowing, and therefore economic activity, but the increase in the money supply can (since the economy is merely sluggish, and not in recession) create inflation. Very low interest rates in the early 2000s in the United States caused asset-price inflation, with destructive consequences, as we know.
Inflation can have other political objectives besides stimulating the economy in order to improve a government's popularity. It is a method of taxation. Suppliers are required by law to accept the official currency in payment of debts, so government can buy goods and services just by issuing money to its employees and other suppliers without having to raise the money by borrowing or by (explicit) taxation. The suppliers will respond by raising prices, but if the government refuses to pay (for example, refuses to raise wages), then the suppliers, to the extent dependent on the government for business (or employment), will have to accept the cheapened money.
In addition, inflation can be used to benefit some groups in society at the expense of others. Inflation benefits debtors, when debt is not indexed for inflation, and hurts creditors. A strongly pro-creditor central bank might even engender deflation, which would mean that debtors would be repaying their debts in dollars worth more in purchasing power than when they took out their loans. A central bank might do that (reduce the money supply, so that the purchasing power of a given quantity of money increases) in order to strengthen its currency, which would enable the country to buy imports more cheaply and increase the return on its foreign investments. (That was the ground on which Britain deflated by returning to the gold standard after having gone off it in World War I. That was a government decision; there was no independent central bank.)
Since the harms of inflation are now widely recognized, a central bank that focuses on limiting inflation will be reasonably popular; and since the value of its being independent of political influences so that it will limit inflation (and deflation) will be recognized, its independence will not be challenged. But the independence of the central bank in the United States, as in other countries, is not guaranteed by the Constitution, as the independence of the federal judiciary is. It is a matter of statute, and Congress could eliminate or reduce the Federal Reserve's independence from the normal political process at any time. Its independence is therefore legally precarious.
That is part of the reason why the modern Federal Reserve has focused on controlling inflation, and, specifically, why it did not prick the housing bubble of the early 2000s, as it could have done at any time by pushing up interest rates, until the bubble got completely out of hand in 2006 and 2007. Had it pricked the bubble earlier, precipitating a fall in housing prices with consequent defaults and foreclosures, at a time when it was unclear that the run up in housing prices was a bubble, it would have been blamed for causing a recession, because proof of a bubble is difficult.
But in retrospect the hit that the Federal Reserve would have taken by pricking the bubble would have done less damage to its prospects for continued independence than the current depression, and the Fed's response, may be doing. Had the Fed merely pushed down interest rates when it became apparent last summer that the economy was sliding into a recession or worse, it would have been doing something that it was expected to do: the converse of raising interest rates to prevent inflation is lowering interest rates to prevent recession, and this is consistent with stabilization, which is part of the Fed's explicit statutory mandate. The Fed did lower the federal funds (overnight bank lending) interest rate, which has become the conventional way in which it influences interest rates. That rate is now virtually zero, yet the reduction has not done the trick. The reason is that the impairment of the banks' capital (because of their heavy involvement in home mortgage lending) has discouraged the banks from lending, since lending is risky. And so the fact that they can borrow from one another at essentially a zero rate of interest to meet loan demands has not incited them to lend in amounts necessary to maintain economic activity at a normal level.
The Fed in some desperation therefore began last fall lending substantial sums to banks in an effort to increase their safe capital to a point at which they would increase their lending by relaxing their credit standards and reducing interest rates on their loans. The Fed also began buying up private debt (as distinct from government securities), for example credit card debt, in the hope that the sellers of the debt would use the cash they received for their debt from the Fed to issue more debt, that is, to lend more. It even has begun buying long-term private and public (Treasury) debt.
The dangers to the Federal Reserve's independence that are created by such activities are twofold. First, the scale of the Fed's intervention is so great as to create a serious risk of a future inflation, albeit a risk that, at present, the bond markets (judging from long-term interest rates) do not consider large. The Fed in the last year has expanded the supply of money by about a trillion dollars, and is intending to expand it further. In principle, it can reverse the expansion process by selling Treasury securities (and the other debt that it has bought) and retiring the cash it receives from the sale. The problem is that a sudden large withdrawal of cash from the economy could cause interest rates to spike, bringing on a recession, as when the Fed reduced the money supply in 1979-1982 to break the 1970s inflation, which was getting out of hand (it reached 15 percent in 1979). A gradual withdrawal might be too slow to prevent inflation.
It is true that when the Fed buys short-term debt, such as credit-card debt, the transaction unwinds naturally in a short time: the debt is paid by the debtors, and the cash received from them can be retired. But this assumes that the debt is paid in full, which it may not be, and that the Fed does not immediately buy more short-term debt, and perhaps feel obliged to continue doing so, because the market has become dependent on its participation. And the Fed as I said is buying long-term as well as short-term debt, and that does not unwind automatically in the short term; it can be sold but it might be sold at a loss, depleting the Fed's balance sheet and leaving excess cash in the economy to create inflation.
If the Fed's actions precipitate inflation or have other untoward consequences, there is likely to be a political backlash against the Fed. We live at present in a blame culture, and really the Fed is lucky that so far most of the public's and the Congress's and the media's ire has been directed at the bankers rather than at Greenspan or Bernanke.
Second, and perhaps more ominous, the types of intervention that the Fed is now engaged in can create an impression of politicization of financial policy or even of impropriety. If the Fed merely issues an offer to buy some specified quantity of Treasury bills, or an offer to sell some specified quantity of those bills, it is not picking and choosing among companies or industries. But if it decides, or participates in deciding, whether Bank X should be allowed to fail while Bank Y receives a huge bailout, or when it uses its position as a bank's creditor to alter its management or influence its business decisions, it invites accusations of favoritism or worse. (Or when it decides to buy one type of private debt rather than another.) The latest portent is the allegation that Bernanke, the Fed's chairman, participated with Henry Paulson, the then Secretary of the Treasury, in pressuring Bank of America last December not only to go through with its planned purchase of Merrill Lynch but also to conceal Merrill Lynch's immense losses from Bank of America's shareholders. I have no idea whether the allegation is true; but that it should be made at all is an example of the political danger to the Federal Reserve if it becomes involved in the operation of individual banks.
I am not suggesting that the Federal Reserve is wrong to take radical measures to combat a depression. The Fed's "easy money" monetary policy may have warded off a deflationary spiral, which would have been disastrous (there is still a mild deflation--the Consumer Price Index for example is below what it was a year ago--and it could still get worse). And the Fed's bank bailouts may well have limited the decline in lending touched off by the near collapse of the banking industry last September. I merely contend that such measures pose greater threats to the Fed's political independence than would early intervention to prick the housing bubble and by doing so perhaps have prevented the grave economic situation in which the nation finds itself.

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Judge Posner,

As much as I enjoy reading your posts related to the financial crisis, I miss the days when you would write on completely different topics from one week to the next. You might discuss criminal law one week, Intellectual Property the next, doping in sports, and so forth. I miss the variety.

This concern with political influence in the financial system seems of a piece with hand-wringing by others about regulatory over-reaction. Have you also written to warn about the dangers of the financial system taking control of the political system and making both subject to oligarchs?

The old military-industrial complex has now morphed into the financial-political complex with far worse consequences. It has destroyed both the financial system and any semblance of a representative democracy (republic). The Federal Reserve bank and its members and the government (the political machinery) are in a mutually protective relationship. Independence of our central bank? that is a bad joke. There are sufficient examples over the past 30 years to suggest that the political class uses the central bank to correct bad fiscal policy and the central bank does what it can to make the political hacks look good. Check out any congressional hearing at which the "witness" is a fed chairman. The name of the hearing chairan is always Peter and the name of the "witness" is always Paul.

Central banks are given independence of the political process, by the political process, for a purpose. When they fail to discharge that purpose satisfactorily, their independence is always at risk; and properly so.

Prima facie, many central banks and other financial regulators, including the Federal Reserve, failed in their regulatory purpose in the lead up to the current crisis. The political process (which also failed to perceive the dangers) now needs to consider what lessons are to be learnt, what changes are needed and which financial regulatory agencies should have their purposes revised.

All that seems business being conducted as it should be in circumstances which are unusual, but in their general characteristics almost inevitably recurrent.

As to the lessons to be learnt, I judge that the housing bubble as such was no proper business of the Federal Reserve. However, the creditworthiness of new financial instrumente, including those derived from mortgages, was proper Fed business and was neglected. That neglect allowed the leveraging which produced the housing bubble; and allowed the obscure tangle of derivatives liabilities.

First, do we need a central bank given that we did not have one for the first 125 years of the nation's existence?
Second, if the answer to the first question is "yes", then why is the Fed currently allowed to stray from it's original mandate to be the lender of last resort, i.e., to provide liquidity for those institutions having such a problem? It is a far cry from that to the perfomance of the Federal Reserve in the last 6-8 monts including, as Judge Posner noted, the allegation recently made against Paulson and Bernanke concerning pressuring B of A to purchase Merrill.
I believe that the Framers would be astounded to see so much power concentrated in what are essentially private banks nominally run under government auspices.

Ah Yes ... "Politics does make for strange bed fellows". The real question becomes, "Can they get of that bed when it becomes necessary"? Only time will tell. For the good of the Nation, I hope the answer is yes and that the Private Financial Infrstructure does not subsume the Federal Reserve and Treasury. If they do, for the good of the Country, we may be forced to Nationalize.

Neil: I keep wondering about the decisions not to nationalize. On the one hand it seems a cleaner way of mopping up the mess and then selling off the businesses in appropriate categories and in much smaller sized institutions.

But! how would it have looked for America's most "conservative" administration to come out padlocks in US Marshal's hands that Monday morn.

Too, we'd be saddled with the whole mess, I assume with "management" absolved of their negligence and lining up to be highly paid consultants on the government dime, err.... millions.

Do you get the feeling there is more rot than has yet been revealed by the excavation so far?

Ha! A friend has a temp job at Gottschalks helping to sell off the final inventory and fixtures; always a sad time in retail as folks are working hard for the same crummy pay with the result being that of being out of work in another rapidly contracting sectors. She wondered aloud as to what might be done with the space. Ahh, yes don't we all.

Jim: Liked your first post but let's agree that your friend O'rourke doesn't bring much wisdom with his "humor". Having a government, or any endeavor larger than a solo walk in the woods, without "politics" or politicians is a bit like trying to build a house w/o carpenters.

Posner asks whether the Fed is losing its independence. He shows some concern for their not being brave enough to have slowed housing, but I've more concern that they were asleep at the switch.

Most of us don't think too much about whether the roll-back of Glass-Steagal and the consequent mergers of goliaths and mixing of activities that were once competitors operating at arm's lengths was a good idea or not.

(I thought not, but my opinion might have been swayed by a strong suspicion that Phil Gramm has long used his PhD in econ for subversive and self-serving purposes only.)

Many of us have heard about derivatives, fewer of us lay-folk had some idea how they worked but VERY few would have had any idea how they were being worked and how massive was their impact on the worlds's financial sector.

MY concern is "independent" or not, that the Fed has the tools to know about these movements of capital....... or should I say analogs in the place of capital? But didn't? Or knew but didn't say or do anything? I mean come on Prof Posner this was not some small "error" of judgment as to whether to tighten by a few basis points.

Or put another way, while the Fed governors/bankers were meeting and discussing a bit of tweaking, did none of them know that the likes of Goldman were "printing" money at a rate never seen before? Did they not ask something along the lines of "Where the hell is all this money coming from to fund unprecedented numbers and amounts of mortgages?"

Or? perhaps in a casual moment over some lunch during the eight year period of unprecedented home appreciation in virtually every market, "How do you suppose these no doc loans for folks with credit scores under 50 are working out for those buying gobs of 'em?"

I understand that spotting bubbles MIGHT be difficult, but surely a few rudimentary econometrics combined with peering out the window once in a while would have divulged the anatomy of the housing/derivates ---- sorry I can only call it a Ponzi.

Posner seems still unaware that the non-banks "created" far more money via massively leveraged derivatives than did the Fed.

In short........ are we more fearful, as Posner suggests of their spinelessness, or of their ignorance? How could they have missed this for eight years when they and legions of assistants have access to the best of computer information and modeling?

In Posner's conclusion he suggests that when the Fed and a host of others finally woke up and did what was necessary and unavoidable that it was those actions that opened them up to being less "independent?"

How so? When they finally discovered that instead of being in a mildly inflationary environment that instead the world's "financial sector" was short a few tens of trillions and would be facing a deflation that would break eardrums unless something bold and clearly in their purview was done? Isn't that what we expect them to do? Independently?

Jack, I have the dubious feeling that the current "Financial Infrastructure" was and has been built on shifting sands as opposed to bedrock. A Financial Infrastructue without an Agricultural, Industrial, or Commercial foundation and base is bound to fail. Alarming, huh?

I think the point is that politics has become a "thing" for it's own sake and not in the rational service of the community. It is like saying all food has to be fried. When poor old Arlen Specter at age 80 thinks that there is no one in Pennsylvania who could do his job as well as he, there must be a certain delusion in the process. Or when Dick Durbin lists on his web site that his occupation is "legislator', things have become somewhat unbalanced.

I like Arlen Specter. I voted mostly for Democrats in the last election, Obama and all, But I voted for Specter because I think he does a good job, and does what he thinks is best for the country. If you use the criteria that he has to "think he's the best person in the world to represent Pennsylvania" you restrict your office to be held only by cocky idiots. He's far and away the person I feel has done the best job representing me. He was a Republican before the current asshats took over the party, then compromised with them for what I felt was too long already, while they used their power to undermine him. Obama is in the running for that crown, but if he wants it he'd better get his act together, and Arlen is in what looks to me like a SPECTACULAR bargaining position to help make things happen. And things need to happen, filibustering until this problem goes away is not acceptable.

Note that the Fed supported the deregulation of Credit Default Swaps (CDS). These are probably the most important derivatives in financial markets today because they allow highly leveraged institutions like banks to hedge their risks. In a CDS, the risk of the loans that these banks make are taken over by counter-parties like AIG or foreign investors. The CDS is economically an insurance contract but it has never been regulated like insurance. It is also traded like a security but it was never regulated as a security either. It was traded, like most derivatives, under a caveat emptor philosophy. There lies the puzzle: why did it seem like a good idea to implement caveat emptor in the derivatives market when every analogous market had abandoned such a hands off approach?

It appears that the Fed came to see CDSs as a panacea for financial crises like Long Term Capital Management. Mr. Greenspan discussed CDSs after reviewing the LTCM incident;. Find below Mr. Greenspan's note on CDSs in his book, "The Age of Turbulence" at pages 371-72:

"A recent financial innovation of major importance has been the credit default swap. The CDS, as it is called, is a derivative that transfers the credit risk, usually of a debt instrument, to a third party, at a price. Being able to profit from the loan transaction but transfer credit risk is a boon to banks and other financial intermediaries, which, in order to make an adequate rate of return on equity, have to heavily leverage their balance sheets by accepting
deposit obligations and/or incurring debt. Most of the time, such institutions lend money and prosper. But in periods of adversity, they typically run into bad-debt problems, which in the past had forced them to sharply curtail lending. This in turn undermined economic activity more generally.
A market vehicle for transferring risk away from these highly leveraged loan originators can be critical for economic stability, especially in a global environment. In response to this need, the CDS was invented and took the market by storm. The Bank for International Settlements tabulated a worldwide notional value of more than $20 trillion equivalent in credit default swaps in mid-2006, up from $6 trillion at the end of 2004. The buffering power of these instruments was vividly demonstrated between 1998 and 2001, when CDSs were used to spread the risk of $1 trillion in loans to rapidly expanding telecommunications networks. Though a large proportion of these ventures defaulted in the tech bust, not a single major lending institution ran into trouble as a consequence. The losses were ultimately borne by highly capitalized institutions‚Äîinsurers, pension funds, and the like‚Äîthat had been the major suppliers of the credit default protection. They were well able to absorb the hit. Thus there was no repetition of the cascading defaults of an earlier era."

The idea, supposedly, was the CDS counter-parties were so rich that they could save the banks, and therefore the economy, in case of major defaults. This has turned out to be wrong. Too many counter-parties were duds.

Uzair, CDS Derivatives: I loan Mr. X one million dollars. Mr. X sells the loan to Mr. Y, who turns around and sells it to Mr. Z in Antigua. Everyone's fat and happy. One problem, Mr. Z is a dummy Corporation, Mr. Y has fictious address on Wall Street and Mr. X is a name on a headstone. Question, "What happened to the million dollars"?
Answer, "I pocketed it".

Derivatives are nothing new, they're just a new twist on the old "Shell/Con Game". Now take this to the level of multi-trillion dollar level and one gets an understanding of the extent and depth of the problem.

I have long thought that we in this country spend way to much attention to "what" happened and not enough on "why" it happened. According to Martha Stout, a psychologist at Harvard who has studied the subject for years, about 4% of persons are born without a conscience, sociopaths if you will. In the United States that would be 12 million persons, many of whom have talent and ambition and rise to positions of prominence in commerce and/or politics. Think the total combined population of New York and Chicago made up of Blagojevichs or Madoffs or Hitlers. Put a clever financial scheme in a few of their hands and Eureka!

Neil: I suppose, legally, the question is did "someone" make the Ponzi just complex enough that nearly all of the perps can claim to have "just been doing their jobs" and to have known nothing? Yah...... sure! I'll bet Wall Street drinking holes rang with predictions of the whole thing tumbling down.